The problem is that if a bank thinks it is too big
to be allowed to fail, it has an incentive to take on a lot of risk,
confident that the government will have its back if it gets into trouble.

I'm interested in hearing your thoughts on financial institutions are are deemed too big to fail. On my page there is a link to the Minneapolis Fed. They have taken the lead on analyzing too big to fail.

Friday, July 20, 2012

Why off balance sheet activities need to be on balance sheet activities. Goldman Sachs was selling CDO's to investors, while at the same time telling top clients and investors to purchase credit default swaps against the very same securities they were selling. That is wrong!

The complaint states that Paulson made a $1 billion profit from the
short investments, while purchasers of the materials lost the same
amount. The two main investors who lost money were ABN Amro and IKB Deutsche Industriebank. IKB lost $150,000,000 within months on the purchase. ABN Amro lost $840,909,090. Goldman stated the firm also lost $90 million and did not structure a portfolio that was designed to lose money. After the SEC announced the suit during the April 16, 2010 trading day,
Goldman's Sachs's stock fell 13% to close at 160.70 from 184.27 on
volume of over 102,000,000 shares (vs. a 52 week average of 13,000,000
shares). The firm's shares lost $10 billion in market value during the
trading session. On April 30, 2010, shares tumbled further on news that the Manhattan
office of the US Attorney General launched a criminal probe into Goldman
Sachs, sending the stock down more than 15 points, or nearly ten
percent to $145.

This is going to be a running post on articles talking about the need for bank capital.

I will also be posting articles under the arguments for and against a
strict bank capital requirement. Like any policy we need to understand
the costs and benefits of added bank capital. The costs are reduced
lending, the benefits are a reduced likelihood of a financial crisis. Here are the results from the Basel panel.

Here is recent article from the WSJ talking about recent moves toward more bank capital. Of course Citi Bank does not like the requirements.

Here is the first article from The Economist. This article talks about increased bank capital during the onset of the financial crisis. How much capital is enough?

The Basel Accord has been an attempt to standardize bank capital requirements across countries. Here is an article talking about Basel III.

A panel
discusses the effects of bank capital requirements on economic growth.
The pros are simple, more capital reduces the likelihood of a bank
become insolvent due to large loan write downs. The costs are simple,
the more capital reduces the return on equity for bank owners.

I'm in favor of strict capital requirements for all bank-like
institutions. I believe the financial system in a large way acts as a
public good. Because of the problems posed by banks failing to fully
account for the costs of risky behavior (yes, largely created by the
types of regulations we currently have) large banks do not recognize the
costs to society. I view capital requirements as an easy but highly
effectively way of minimizing regulations while allowing banks to serve
society (i.e. channeling funds from borrowers to savers). I like these
requirements mainly because banks still have a choice for the types of
assets they want to hold. If banks want to undertake in subprime lending
they can, but it needs to be supported by added capital. Will this slow
down growth, probably in the short run, but in the long run it will
lead to fewer financial crises. Given the recent number of crisis that
could have been avoid if banks were holding adequately capital, I view
the long run benefits as a necessary.

I am a big proponent of increasing capital requirements (especially on banks that are deemed too big to fail). The World Bank produced a nice report summarizing capital requirements and leverage during the mid-2000s. Here is a discussion in the Economist about capital requirements.

My preference for capital requirements would that they are increasing with the overall size of the balance sheet, riskiness of the assets held, and the greater the level of interest rate risk.

Here is a good article from the Economist supporting capital requirements:

Two numbers stand out. First, the short-term cost of tougher
rules is fairly low: assuming a three-percentage-point increase in
capital ratios and a four-year implementation period, absolute GDP would
be just 0.6% lower than it would otherwise have been. Second, and
offsetting the first effect, once the new rules are in place the
benefits from having fewer crises are big. In a base case and assuming a
three-percentage-point capital-ratio increase, the absolute level of
GDP rises by some 1.7%.

Over the last three years there has been tremendous attention into
financial reform. A major theme in our class will be discussing the role
financial markets play in the economy and how to go about regulating
these markets. Recently the US passed the Dodd-Frank bill which attempts
to prevent future financial crises. Unfortunately, one area the bill
fails to address is the need for bank capital requirements. Before
getting into the gory details it may help to provide a brief side note
on the role of bank capital.

Like any firm banks have assets and liabilities. Asset include loans
made to households and business and government bonds. Liabilities
include demand deposits (checking accounts) IRAs, and CDs, basically our
accounts with banks. Bank capital is the difference between assets and
liabilities. It shows up on the liabilities side of the balance sheet.

Banks prefer to not hold excess capital, they would prefer to pass the
capital onto the owners in the form of equity or use the funds to create
more loans. Nonetheless capital helps banks insurance against large
loan losses. Remember loans (notably housing and commercial loans)
appear on the asset side of the balance sheet, when banks experience
large loan losses the asset side of the balance sheet decreases. If loan
losses are large enough bank assets could become less than liabilities
making the bank insolvent (i.e. the bank fails). Now because bank
capital is a liability it helps offset loan losses.

Suppose you have two banks (A and B). Bank A has $100 million in capital
and Bank B has $25 million. Each bank experiences large loan losses and
writes down their assets by $50 million. Bank A will be left with $50
million in capital but Bank B will be insolvent with a net worth of -$25
million. If we go back 2 years, banks that failed lacked sufficient
capital to insure against large loan losses.

Jump ahead to today and we still have not solved the bank capital
requirements. Wall Street has argued against capital requirements,
forcing banks into holding added capital will sufficiently hamper
lending. I firmly believe we need to institution capital requirements
based on three components:
1) The size of a bank's balance sheet. If mega banks pose added risk to
the economy we need to force them into holding more capital.
2) The composition of a bank's assets. If banks want to hold riskier
assets (i.e. subprime mortgages) we need to require greater capital
requirements.
3) The composition of a bank's liabilities. If a bank has liquid
liabilities (i.e. dependent on short-term financing) they are more prone
to experience a bank run and a loss of funding, holding greater levels
of capital will temper this threat.

The basis for my argument comes from the last 20 years of banking
crises. We have seen large financial crises occur in Asian, Latin
America, Scandinavia, and now the United States. In nearly every case
banks did not hold sufficient amounts of capital. The solution to our
financial crisis was to inject major banks with added capital (remember
TARP). If banks were holding sufficient capital we could have prevented
needing to bailout nearly every large bank.

Of course there was a fear of a large slowdown in global growth. Well,
it turns out the costs of financial crises trumps the reduction in
growth from a slowdown in banking lending. Banks would be forced into
more due diligence when issuing loans and likely choose safer
investments.

Friday, July 13, 2012

On of the new chapters in the 6th edition of Kindleberger discusses Bernie Madoff. Fully admitting I still need to read this chapter (as I have the 5th edition), I am posting a Frontline video that discusses Bernie Madoff.

There has been many attempts to try and explain the financial crisis. In my eyes there were no less than a dozen factors that contributed to housing bubble, housing collapse, and financial meltdown. A bubble is a lot like a forest fire that gets out of control. You need fuel (usually not one or two trees but a forest filled with overgrowth), you need the spark to ignite the fire (lightening). Finally, you need an accelerant (high winds).

In the case of the housing bubble the fuel was provided by decades of poor regulation and deregulation (alone each case is fine). For example, during the 90's we had a campaign to make everyone a homeowner (great idea, bad when we used subprime loans to do this). Toward the end of the decade we had Gramm-Leach-Bliley (more on this in later chapters) that removed the separation between commercial and investment banks (fine if commercial banks were stocked full of subprime mortgages desperately need buyers, enter investment banks).

The spark was a large amount of money flowing out of the stock market into the housing market. Domestic investors needed a home for their money after the collapse of the dot.com bubble.

Finally, you need the accelerator. Domestic money was not sufficient to sustain the low interest rates homeowners craved. If there were only a way to attract foreign money (enter China, OPEC, Europe, Banking centers). Here we have the global savings glut. The inflow of cheap foreign capital prevented long-term interest rates from rising giving us the accelerant needed to sustain and prop up our housing bubble.

I have the 5th edition (copyright 2005). Here is the quote on the cover:

I have been having my students read this book since 2005. Unfortunately, it was not because I thought we were headed into a potential Great Depression like crisis, but because I have a passion for understanding financial crises.

Wednesday, July 11, 2012

Early in Kindleberger he elabortates on Hyman Minsky's theory of financial instability. In what was does Minsky's theory fit with the current financial crisis. Here is a Fed speech by Janet Yellen that may help. Sadly, following the financial crisis, economists quickly realized the literature was rather dated and economic research for the last 30 years left us helpless in understanding the crisis. We turned to work by Minsky.

One of the challenges teaching this course is finding ways to incorporate (and sort through) the wealth of articles that are being published related to money, banking, and financial markets. Here is a nice article by John Williams (President of the FRBSF) discussing the relationship between monetary policy, money, and inflation (see chapter 3). Pay particular attention to the discussion on paying interest on bank reserves and the incentives for banks to lend out excess reserves.

It is disturbing that 26% of bankers will admit to behaving unethically if it makes them better off. This is also the number that is willing to come forward, I am sure there are others that will behave in a way that could harm society, but are not willing to come forward. Any one still questioning why Wall Street needs to be regulated?

Monday, July 9, 2012

Here is a blog post by Martin Wolf of the Financial Times discussing the real interest rate (the post is a few months old, but still worth reading and discussing.

On area that is starting to gain a lot of attention on main street is the erosion of retirement savings. In response to the financial crisis interest rates have fallen to record lows (short-term rates by the Fed, long-term rates due to global uncertainty and savings glut). A low nominal rate combined with modest inflation (1-2%) has left many retirees earning 0% (and in some cases negative). At the same time, many of those over 45 have benefited from low taxes, a dot com bubble, and a housing bubble.

Friday, July 6, 2012

Here is a recent article discussing how Countrywide used special loan packages for VIPS (government officials and many working for Fannie Mae) to gain preferential treatment for their subprime loans:

"Other than Countrywide, no other entity's employees received more VIP
loans than Fannie Mae," Issa said in a release. "These relationships
helped Mozilo increase his own company's profits while dumping the risk
of bad loans on taxpayers."

There are two main issues that need to be discussed. First, there is needs to be separation between financial firms and government officials. How can we expect elected officials to pass important regulations when they receive generous benefits from the institutions they are trying to regulate (read Paulson's secret Russian meeting).

The second issue is the role of Fannie Mae and Freddie Mac. Here are two private companies that operated as a government sponsored enterprise. They were free to take on excess risk, knowing they had the full backing the US government should they fail. They were free to go after excessive profits (through buying Countrywide's subprime loans) without facing the risks. Fannie and Freddie play an important role in the financial system. Banks issue 30-year mortgages and then sell them to Fannie/Freddie. The mortgages then get bundled and sold to investors all over the world. Fannie and Freddie then use this income to purchase more home loans. This process allows banks to issue more home loans. The problem now becomes risk. Banks no long care about repayment since they are selling the loans to Fannie and Freddie. This provides the perfect environment for creating more subprime mortgages.

Tuesday, July 3, 2012

I would like everyone to read Bernanke's speech following the monetary policy response of the financial crisis. You can find the speech here.

There will not be discussion questions for chapter 1. It is really an introduction chapter. I will have narrated notes posted for chapters 1 and 2 by Wednesday. I am still getting back on my feet after my flight back from Italy. For now, keep up on the blog posts and read over chapter 1.

Sunday, July 1, 2012

I am currently traveling back from Italy on Monday and will be back in Spokane late in the afternoon. I have not entirely completed the course outline and lecture notes for the first week. I should have everything up and going Monday evening, Tuesday morning. For now I would like everyone to look through the first chapter in Wright (lecture notes are posted, not narrated) and work on the discussion questions I have posted. In addition to the first chapter please watch the video, "The Warning".

When watching the video I want you to think about the role the financial system should play in society. The ultimate goal of the financial system is to channel from from savers to lenders. From society's point a view the financial system should be to promote growth and regulated in a way that improves societal welfare. At the same time, financial intermediaries have a difficult job and are private firms that are entitled to maximize their profits. At what extent should financial intermediaries be able to pursue maximum profits in terms of risky assets?

You can probably see where I am going with these questions, there are no right answers. The goals of financial firms and society are different, but at the same time we want financial firms to provide us with the greatest returns, which means taking on more risk. Of course, households don't think of this and the costs of a financial crisis. Well they didn't until the last few years. We will get into many more questions, for now I just want you thinking about the role of financial intermediaries in a market economy.